Friday, January 20, 2012

There has been a lot of hand wringing over the years about the problem of counterfeiting and copyright piracy in China. The Chinese, it is said, have no respect for intellectual property and will copy anything. Many have advocated tough solutions to deal with the piracy problem.

Things are changing because the Chinese economy is moving up the value chain. Patrick Chovanec wrote these words back in 2010:

Back when I was a private equity professional investing in China, I’d say that 9 out of every 10 opportunities I saw involved what I would call “commodity” manufacturers — factories that churned out a standardized, low value-add product that virtually anyone could make, and competed solely on price. Even though they accounted for a big chunk of China’s productive capacity, and often were making good money, we did everything we could to avoid such investments. We figured that, whether in one year or ten, these companies would inevitably lose their purely cost-based competitive advantage as China’s economy developed. They represented China’s past, not its future.

In other words, Chinese companies were commoditized manufacturers competing on their low-cost producer status. The new breed of companies are moving up the value chain:

At least one out of every ten Chinese companies we looked at, though, had more promise. Either they were making something unique, or they were doing something markedly better than their competitors: achieving higher quality, reaching more markets, building a brand name, etc. Often their costs were higher. Among other things, they had to hire better, more expensive employees, not just in production, but in sales, marketing, and customer service. They had to invest in training and sometimes even in partnerships with local schools to ensure a steady stream of qualified workers as they expanded. Like any investment, it was a risk, but it had the potential to pay off by setting them apart from the low-cost, low value-add pack. These are the companies we were betting would own the future.

The trend that Chovanec wrote about is starting to show some results. The Economist reports that Chinese consumers are starting to pay more attention to brands and shun counterfeiters:

Counterfeiters are no longer popular. Not long ago, Chinese shoppers applauded the fakers for saving them money. Now they scorn them. If it’s a fake, the well-heeled sneer, you can’t flaunt it...

Still, as China grows richer, life is growing harder for fakers. A recent study of China’s luxury market by Bain, a consultancy, concludes that “demand for counterfeit products is decreasing fast.” McKinsey, another consultancy, found that the proportion of consumers who said they were willing to buy fake jewellery dropped from 31% in 2008 to 12% last year. This is good news for all brands, not just the blingy ones. “Consumers are looking for the real thing, and they are increasingly willing and able to afford it,” say the authors.

That's because the Chinese have moved up the value chain:

Another reason why fakers are under pressure is that Chinese firms now have intellectual property of their own to protect. Brands such as Lenovo (a computer firm) and Haier (a maker of everything from fridges to air-conditioners) are highly valuable and therefore worth defending. The more Chinese innovators gripe about fakery, the more strictly the government enforces the law. It just announced that it aims to stamp out counterfeit software in government offices by the end of this year.

The Chinese are on a well trodden path followed by other Asian economies that have migrated up the value chain, such as Japan (those of us old enough still remember the ridicule of the cheap Japanese imports from the 1960's), South Korea, Taiwan, etc. The latest five year plan calls for more balanced growth and high value-added exports. While the jury is out on the first objective, they seem to be fulfilling at least on the second part.

This story illustrates the indirect way to fight intellectual piracy as the problem of is going away naturally of its own accord. Yes, Greg, people do respond to incentives.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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